Financing Secrets of a Millionaire Real Estate Investor By William Bronchick

Personal Finance

Financing Secrets of a Millionaire Real Estate Investor
By William Bronchick

Contents

1. Introduction to Real Estate Financing

Understanding the Time Value of Money

The Concept of Leverage

Owning Property “Free and Clear”

How Financing A ffects the Real Estate Market

How Financing Affects Particular Transactions

How Real Estate Investors Use Financing

When Is Cash Better Than Financing?

What to Expect from This Book

Key Points

2. A Legal Primer on Real Estate Loans

What Is a Mortgage?

Promissory Note in Detail

The Mortgage in Detail

The Deed of Trust

The Public Recording System

Priority of Liens

What Is Foreclosure?

Judicial Foreclosure

Nonjudicial Foreclosure

Strict Foreclosure

Key Points

3. Understanding the Mortgage Loan Market

Institutional Lenders

Primary versus Secondary Mortgage Markets

Mortgage Bankers versus Mortgage Brokers

Conventional versus Nonconventional Loans

Conforming Loans

Nonconforming Loans

Government Loan Programs

Federal Housing Administration Loans

The Department of Veterans A ffairs

State and Local Loan Programs

Commercial Lenders

Key Points

4. Working with Lenders

Interest Rate

Loan A mortization

15-Year A mortization versus 30 -Year A mortization

Balloon Mortgage

Reverse A mortization

Property Taxes and Insurance Escrows

Loan Costs

Origination Fee

Discount Points

Yield Spread Premiums: The Little Secret Your Lender

Doesn’t Want You to Know

Loan Junk Fees

“Standard” Loan Costs

Risk

Nothing Down

Loan Types

Choosing a Lender

Length of Time in Business

Company Size

Experience in Investment Properties

How to Present the Deal to a Lender

Your Credit Score

Your Provable Income

The Property

Loan-to-Value

The Down Payment

Income Potential and Resale Value of the Property

Financing Junker Properties

Refinancing—Worth It?

Filling Out a Loan Application

Key Points

5. Creative Financing through Institutional Lenders

Double Closing—Short-Term Financing without Cash

Seasoning of Title

The Middleman Technique

Case Study #1: Tag Team Investing

Case Study #2: Tag Team Investing

Using Two Mortgages

No Documentation and Nonincome Verification Loans

Develop a Loan Package

Subordination and Substitution of Collateral

Case Study: Subordination and Substitution

Using Additional Collateral

Blanket Mortgage

Using Bonds as Additional Collateral

Key Points

6. Hard Money and Private Money

Emergency Money

Where to Find Hard-Money Lenders

Borrowing from Friends and Relatives

Using Lines of Credit

Credit Cards

Key Points

7. Partnerships and Equity Sharing

Basic Equity-Sharing Arrangement

Scenario #1: Buyer with Credit and No Cash

Scenario #2: Buyer with Cash and No Credit

Your Credit Is Worth More Than Cash

Tax Code Compliance

Pitfalls

Alternatives to Equity Sharing

Joint Ventures

Using Joint Venture Partnerships for Financing

Legal Issues

Alternative Arrangement for Partnership

Case Study: Shared Equity Mortgage with Seller

When Does a Partnership Not Make Sense?

Key Points

8. The Lease Option

Financing A lternative

Lease—The Right to Possession

Sublease

Assignment

Suggested Reading

Suggested Web Sites

Real Estate Financing Discussion Forums

Index

Sample Pages

Chapter 1

Introduction to Real Estate Financing

Knowledge is power. - Francis Bacon

In 1991, I made my first attempt at financing an investment property through creative means. With a lot of guts and a little knowledge, I made an offer that was accepted by the seller. I tendered $1,000 as earnest money on the sales contract, then proceeded to try to make the deal work. I failed, lost my $1,000, but I learned an important lesson - a little knowledge can be dangerous. I decided then to become a master at real estate finance.

Financing has traditionally been, and will always be, an integral part of the purchase and sale of real estate. Few people have the funds to purchase properties for all cash, and those that do rarely sink all of their money in one place. Even institutional and corporate buyers of real estate use borrowed money to buy real estate.

This book explains how to utilize real estate financing in the most effective and profitable way possible. Mostly, this book focuses on acquisition techniques for investors, but these techniques are also applicable to potential homeowners.

Understanding the Time Value of Money

In order to understand real estate financing, it is important that you understand the time value of money. Because of inf lation, a dollar today is generally worth less in the future. Thus, while real estate values may increase, an all-cash purchase may not be economically feasible, because the investor’s cash may be utilized in more effective ways.

The cost of borrowing money is expressed in interest payments, usually a percent of the loan amount. Interest payments can be calculated in a variety of ways, the most common of which is simple interest. Simple interest is calculated by multiplying the loan amount by the interest rate, then dividing it up into period (12 months, 15 years, etc).

Example: A $100,000 loan at 12% simple interest is $12,000 per year, or $1,000 per month. To calculate monthly simpleinterest payments, take the loan amount (principal), multiply it by the interest rate, and then divide by 12. In this example, $100,000 × .12 = $12,000 per year ÷ 12 = $1,000 per month.

Mortgage loans are generally not paid in simple interest but rather by amortization schedules (discussed in Chapter 4), calculated by amortization tables (see Appendix A). Amortization, derived from the Latin word “amorta” (death), is to pay down or “kill” a debt. Amortized payments remain the same throughout the life of the loan but are broken down into interest and principal. The payments made near the beginning of the loan are mostly interest, while the payments near the end are mostly principal. Lenders increase their return and reduce their risk by having most of the profit (interest) built into the front of the loan.

The Concept of Leverage

Leverage is the process of using borrowed money to make a return on an investment. Let’s say you bought a house using all of your cash for $100,000. If the property were to increase in value 10 percent over 12 months, it would now be worth $110,000. Your return on investment

The Federal Reserve and Interest Rates The Federal Reserve the Fed is an independent entity created by an Act of Congress in 1913 to serve as the central bank of the United States. There are 12 regional banks that make up the Federal Reserve System. While the regional banks are corporations whose stock is owned by member banks, the shareholders have no influence over the Federal Reserve banks’ policies.

Among other things, the function of the Fed is to try to regulate inflation and credit conditions in the U.S. economy. The Federal Reserve banks also supervise and regulate depository institutions.

So how does the Fed’s policy affect interest rates on loans? To put it simply, by manipulating “supply and demand.” The Fed changes the money supply by increasing or decreasing reserves in the banking system through the buying and selling of securities. The changes in the money supply, in turn, affect interest rates: the lower the supply of money, the higher the interest rate that is charged for loans between banks. The more it costs a bank to borrow money, the more they charge in interest to consumers to borrow that money. The preceding is a simplified explanation, because there are other factors in the world economy that affect interest rates and money supply. And, of course, there are also widely varying opinions by economists as to what factors drive the economy and interest rates.

would be 10 percent annually (of course, you would actually net less because you would incur costs in selling the property).

Equity = Property value – Mortgage debt

If you purchased a property using $10,000 of your own cash and $90,000 in borrowed money, a 10 percent increase in value would still result in $10,000 of increased equity, but your return on cash is 100 percent ($10,000 investment yielding $20,000 in equity). Of course, the borrowed money isn’t free; you would have to incur loan costs and interest payments in borrowing money. However, by renting the property in the meantime, you would offset the interest expense of the loan.

Calculating Return on Investment

Annual return on investment ROI is the interest rate you yield on your cash investment. It is calculated by taking the annual cash f low or equity increase and dividing it by the amount of cash invested.

Let’s also look at the income versus expense ratios. If you purchased a property all cash for $100,000 and collected $1,000 per month in rent, your annual cash-on-cash return is 12 percent (simply divide the annual income, $12,000, by the amount of cash invested, $100,000).

If you borrowed $90,000 and the payments on the loan were $660 per month, your annual net income is $4,080 ($12,000 – [$660 × 12]), but your annual cash-on-cash return is about 40 percent (annual cash of $4,080 divided by $10,000 invested).

So, if you purchased ten properties with 10 percent down and 90 percent financing, you could increase your overall profit by more than threefold. Of course, you would also increase your risk, which will be discussed in more detail in Chapter 4.

Owning Property “Free and Clear”

For some investors, the goal is to own properties “free and clear,” that is, with no mortgage debt. While this is a worthy goal, it does not necessarily make financial sense. See Figure 1.1.

Example: Consider a $100,000 property that brings in $10,000 per year in net income (net means gross rents collected, less expenses, such as property taxes, maintenance, utilities, and hazard insurance). The $100,000 in equity thus yields a 10 percent annual return on investment ($10,000, the annual net cash f low, divided by $100,000, the equity investment).

If the property were financed for 80 percent of its value ($80,000) at 7.5 percent interest, the monthly payment would be approximately $560 per month, or $6,720 per year. Net rent of $10,000 per year minus $6,720 in debt payments equals $3,280 per year in net cash f low. Divide the $3,280 in annual cash f low by the $20,000 in equity and you have a 16.4 percent return on investment. Furthermore, with $80,000 more cash, you could buy four more properties. As you can see, financing, even when you don’t necessarily “need” to do so, can be more profitable than investing all of your cash in one property.

How Financing Affects the Real Estate Market

Because financing plays a large part in real estate sales, it also affects values; the higher the interest rate, the larger your monthly payment. Conversely, the lower the interest rate, the lower the monthly payment. Thus, the lower the interest rate, the larger the mortgage loan you can afford to pay. Consequently, the larger the mortgage you can afford, the more the seller can ask for in the sales prices.

Also, people with less cash are usually more concerned with their payment than the total amount of the purchase price or loan amount. On the other hand, people with all cash are more concerned with price. Because most buyers borrow most of the purchase price, the prices of houses are affected by financing. Thus, when interest rates are low, housing prices tend to increase, because people can afford a higher monthly payment. Conversely, when interest rates are higher, people cannot afford as much a payment, generally driving real estate prices down.

Since the mid-1990s, the prices of real estate have dramatically increased in most parts of the country. The American economy has grown, the job growth during this period has been good, but most important, interest rates have been low.

Note: the rest of the chapter is omitted